Code to joy

The Financial Reporting Council has been consulting the users and preparers of accounts about the impact of its Combined Code on corporate governance. According to the accountants we asked, it is working well. And, they said, at least it isn’t Sarbanes-Oxley. Richard Young writes

In April the Financial Reporting Council (FRC) invited interested parties to submit views on the impact of the Combined Code, the corporate governance framework introduced for UK-listed entities in 2003. The review, says the FRC, will consider whether the code is appropriately enabling UK-listed companies to be led in a way which facilitates entrepreneurial success and the management of risk.

Many finance directors and senior accountants welcomed the code. Issues that had a tendency to become buried in the finance function (such as financial risk management, the audit process, internal controls and the clarity of the annual report) suddenly moved up the board agenda. Better yet, while the code contains a number of provisions in addition to its founding principles (see box), the FRC included a rider that allowed boards not to apply them providing they told shareholders why – the so-called ‘comply or explain’ principle.

The first review of the code, in 2005, changed very little. So, as the FRC winds up the 2007 review this month, has anything changed? And does the UK corporate governance regime get a thumbs-up from those applying it? We asked Paul Moxey, ACCA’s head of corporate governance and risk management; ACCA member Neil Preston, company secretary of the FTSE100 leisure group Punch Taverns; Ashley Martin, FD of the fast-growing construction group ROK; and Will Coker, CFO at the AIM-listed Berkeley Scott Group.

At least it isn’t Sarbanes-Oxley

One common and overwhelming view is that UK companies are doing far far better by their governance rules than their US counterparts using the Sarbanes-Oxley Act 2002 (SOX), introduced as a result of the Enron and WorldCom scandals. ‘SOX was an over-reaction – and you only have to look at all the de-listings in the US to see the effect it’s had,’ says Martin. ‘While the instinct was right, it has just gone too far. The UK seems to have got the balance right between guidance to shareholders and allowing management to operate.’

Moxey echoes that approval. ‘When one looked at Sarbanes-Oxley, it was easy to be thankful that we had the Cadbury Code, a simple, two-page set of principles against the mass of rules in the US version,’ he says. ‘The Combined Code is a bit longer now, of course, but it maintains that focus on a set of principles – the ideal approach.’

The authorities in the US are now considering whether and how to reform SOX to halt the trend of companies floating elsewhere (often London) in order to escape its provisions. No such widespread review of the Combined Code is expected.

Comply or explain

‘The big advantage with the code is that you can avoid the more onerous provisions – although it seems as if few investors follow up on the “explanations”,’ says Moxey. ‘And institutional investors tend to have less time to examine “comply or explain” in smaller businesses’ reports. So there is a danger that non-compliance – no matter how well explained – could filter smaller companies out of their investment plans.’

There is also an emerging third-party factor. Organisations such as PIRC and Manifest advise shareholders on how to vote at AGMs. This can result in tension between investors and the board, regardless of the explaining they do. ‘PIRC tends to come up with its own governance principles for voting guidance, beyond the requirements of the Combined Code,’ says Preston. ‘That can be difficult to deal with. But providing you set out to follow the principles of the code, it’s only at the edges that you might run into any kind of flak.’

This monitoring of good governance has even filtered down to AIM, where companies are not bound by the code per se. ‘After we’d issued our prelims ahead of the AGM, a company based in Asia got in touch with me,’ says Coker. ‘They’d trawled the accounts and then made a couple of recommendations about which way shareholders should vote on AGM resolutions. Although I don’t think it influenced anyone’s decision, it did make me more aware that we were being monitored.’

So either the monitoring (by third parties) or the filtering (by investment companies) needs to become more attuned to the ‘explain’ component, or one of the most flexible and admired components of the code could become less effective.

Box-ticking

‘There’s always a charge against any governance code that it’s an exercise in box-ticking,’ says Preston. ‘As a listed entity, you do have to ask why you’re engaging in any given practice – is it the listing rules, the Combined Code or because it’s the right way to run the business? We aim to run the business well, and the good news is that everyone seems quite happy with the way we’re doing things.’

All of the people we spoke to were aware of the danger of box-ticking, but all of them had found sound business benefits from applying the principles of the code. Even Coker, as yet outside its remit, says that good governance pays. ‘We apply it almost by default because a lot of it is common sense,’ he says. ‘But you don’t want your business to suffer for something that might just be box-ticking. The main issue is what your values are as a board.’

Martin says really embracing the principles in the code – not simply box-ticking – makes a real difference. ‘It has heightened the profile of risk management – you can’t pay lip service to it any more,’ he says. ‘You have to make sure it’s totally embedded into the management of the company – at ROK it’s at the heart of everything we do, from business plans and budgets right the way through our operations. What’s also important is that it’s not just the FD’s responsibility – risk management belongs to everyone.’

Smaller companies

Smaller companies cannot expect to have the same quality of debate between shareholders and boards on issues like internal control and audit quality. ‘We haven’t really had any influential shareholders asking about governance,’ says Coker. ‘In a smaller business, they’ve been more interested in the bottom line, to be honest.’

But not all the provisions of the code relate to disclosures or processes. ‘The Combined Code recommends a 50:50 split of execs and non-execs,’ says Moxey. ‘That means that some companies have either had to increase the number of non-execs or shrink the number of executives on the board.’ That is one area where Coker feels that AIM companies are lucky to escape the rigours of the code. ‘If there were no other value-add, you’d have to ask why you’d want to add possibly tens of thousands of pounds a year in non-exec fees purely to meet the principles of board composition in the code,’ he says.

ROK has grown somewhat larger than most definitions of a small company, and Martin thinks the non-executive provisions have helped raise the quality of independent directors across the board. ‘Certainly, the capability and contribution of non-execs have improved dramatically in the past four years,’ he says. ‘The influence they have brought to bear and the involvement they have in business are much stronger now. For example, it’s clearly a good idea for audit committee chairmen to have relevant and up-to-date experience, and the code has pushed that higher up the agenda.’ That provision has also increased the demand for accountants to serve in non-executive positions, of course.

The future

So what did our panel think might usefully be changed in what they concede is a generally positive code? For Martin, it is clearer guidance on auditor independence. ‘Because we’re an acquisitive company, we tend to undertake a lot of due diligence,’ he says. ‘It would be simpler to have the same firm that does the audit – and understands how we account for and report on items – undertake that, but I think there’s a perception around auditor independence that isn’t helping management take decisions in the best interests of the company.’

Coming from a situation where his company was in private equity (PE) ownership (Punch floated in 2002), Preston thinks a slightly different emphasis in the remuneration aspects of the code would be beneficial. ‘I genuinely believe that a generous stock option package for the CEO worked really well for us when we were PE-backed, and I just don’t think that would have been possible as a listed company,’ he says. ‘If you’re not careful there can be a nervousness which can then skew decision-making around remuneration.’

Moxey thinks that the best aspects of British accounting should be strengthened in the code. ‘You might argue for a greater focus on the principles and a little less on the provisions,’ he says. ‘The business and investment community is getting more interested in embedding corporate governance in companies, and that’s best enshrined in the code’s main principles.’

One final point worth considering. The Combined Code fulfils many of the requirements of pan-European law on corporate governance. But the Department of Trade and Industry is currently consulting on whether aspects of the 4th, 7th and 8th Directives will require amendments to UK company law – and will potentially mean additional regulation for UK corporate accountants to puzzle over. ‘It seems that there’s a good chance of new legislation – we should know more on that imminently,’ says Moxey. That would be an annoyance, particularly since the FRC seems to have expertly trodden the delicate path between good governance, benefit to business and simplicity of compliance for the nation’s boards of directors.

Richard Young is a freelance writer and editor. He is consulting editor of Real FD magazine.